At one time or another, many of us have been approached by friends, family members, colleagues, or even complete strangers about investing in a private equity deal they are involved with. Having covered in my previous post (LINK) what you can learn from experienced LPs about the decision to place money in an existing fund, now I want to focus on how LPs analyze whether to jump into a specific deal.
In some cases, such deals can be excellent money-making opportunities, while in others they can be a quick path to bankruptcy. When listening to any pitch, it is helpful to remember that over 50% of early-stage businesses fail within three years. So understanding how professional LPs break down a deal’s merits can provide you with a useful analytical lens, whether for co-investing in a private equity fund’s latest deal or investing in your friend’s new [insert buzzword here] startup.
As I mentioned in the previous post, an investor’s default mode should always be skepticism. Depending on your circle of acquaintances and whether you qualify as an accredited investor —which more than 13% of American households now do (Looking for Gains in Private Equity? Tips for the Everyday Investor | CFA Institute Enterprising Investor)—you may find yourself on the receiving end of both highly legitimate and highly questionable investment propositions. The advice in this post will help keep you out of the latter while identifying the former.
A key point to understand is that when an LP analyzes whether to invest in a specific deal (as opposed to a managed fund), they will act much as the GP of a fund does in determining whether a company is a good target for acquisition based on factors such as valuation, growth prospects, opportunities for cost reduction, strength of team, and exit opportunities (How Private Equity Firms Generate Returns | A Simple Model). That said, there are also some factors that are uniquely important as seen through an LP’s lens, which can be incorporated into your analysis by asking yourself the questions below. Think of it as a Socratic method for uncovering superior returns in private equity.
Key Questions For Analyzing a Deal
Who is Spearheading the Deal?
- When thinking about the individuals, groups, or firms driving the deal, ask yourself about their character and trustworthiness. You may be betting a significant amount of money on one person, in particular, who will run the company. If you do not know them well enough to make a judgment call, investigate them objectively and thoroughly, along as many avenues as possible. The right time to vet someone is always before your money is tied up with them.
- If those involved pass the character screening, begin evaluating their past performance in doing what they are proposing to do in the present deal. Their track record should be both relevant to the current deal and indicative of well-above-average abilities.
How is the Deal Structured?
- Now it’s time to delve into the specifics of the deal. What type of security will you receive in exchange for your money (common or preferred equity, convertible debt, etc.) and what level will you occupy in the legal structure surrounding the underlying company and its assets? Is the company a sole proprietorship, partnership, LLC, C or S corporation, or something else? And is your money being invested directly in the acquisition itself, or at some higher level such as a fund or a fund of funds?
- If you are a minority investor in the deal, it’s crucial to fully understand your legal position and the implications of your minority status. There may be assets to which you have limited or no rights if things go wrong. Approach the deal as a credit analyst would—analyze its legal structure and consider worst-case scenarios to assess your potential outcomes. Determine whether there are provisions that allow you to liquidate your holding to a majority investor under certain circumstances, or conversely, allow them to buy you out whether or not you want to exit. These aspects can become complex, so consulting with an attorney is usually advisable.
What are the Economic Terms of the Deal?
- Broadly speaking, the economic terms define the financial returns and economic interests of the investors. This is where your analysis will follow the (hoped-for) money. How will the GP, or majority investor, get paid from the deal? How much of their skin is in the game, and do their incentives align with your own? When and how can investors expect a return of their invested capital? If GPs who aren’t early in their careers are not putting much of their own money in, or stand to make a solid return before LPs do, that is a major red flag.
- What is the schedule for capital deployment and the potential for future capital calls? In some deals, investors may not be required to provide capital until a certain amount of time has passed, while in others, GPs have the potential to call the full amount the day contracts are signed. Another important consideration is whether your share of the deal will be protected by an anti-dilution provision, under which your ownership percentage can be protected through additional rounds of capital raising in which you do not participate.
- If your investment in a “deal” is happening through a club or fund of funds, then like a fund investment, there will probably be fees involved. This is by no means a deal killer, but be aware that fees, especially if they accrue at multiple levels, can significantly erode your returns, particularly if the underlying profits being generated are already middling. Multiple layers of funds also typically mean less transparency, less direct accountability, and a decreased chance of recovery in a worst-case scenario (fraud, bankruptcy, etc.).
How Does the Deal Fit Within My Personal Risk Parameters and Overall Portfolio Allocation?
- If the deal has made it through the traps above, you should evaluate it in terms of its fit for your individual needs and situation. These will vary greatly from one investor to the next. Some private equity investors follow the approach of many venture capitalists, writing dozens of smaller checks hoping for a single home run. Others put money into a small number of stable, “blue chip” deals. Regardless, you should know what type of investor you are, and evaluate how the deal being offered will impact your portfolio in terms of its size, sector, geography and asset type. Can you accept the risk level, and how does the expected lockup horizon and capital call schedule align with your liquidity needs? What are the tax implications? For a variety of reasons, even a seemingly homerun investment may not fit your needs at a given point in time, so never be afraid to take a pass. As Peter Lynch (the Magellan Fund manager, not our Peter Lynch) once said, “Know what you own, and know why you own it.” You will regret a bad deal you made much more than a good one you missed.
Conclusion: Everyone Strikes Out, Just Don’t Make a Habit of It
As you apply the advice above to your own investment opportunities, remember that anyone—even a highly experienced, rock-star investor—can make a mistake. In 1993, for instance, Warren Buffett paid $433 million for Dexter Shoe Company, calling it “one of the best-managed companies Charlie [Munger, Buffett’s close friend and partner] and I have seen in our business lifetimes.” By 2001 Buffett’s shoe investment was racking up huge losses, and in 2007 he pronounced Dexter a “worthless business.” In investing as in baseball, even the best strikeout. But taking the time to thoroughly vet any deal offered to you from every conceivable angle will, over time, be the difference between life-changing deals of the good variety and those of the bad variety. And the more deal vetting you do, the more you will find ways to optimize the process for efficiency. Some LPs even build out a small-scale version of the kind of diligence infrastructure that funds employ, such as by hiring a part-time analyst or cultivating a stable of advisors and contacts. Whether this model fits your needs or not, you can at least develop a trusted network to augment your own analysis efforts. As we like to say at ASM, if you don’t know something, ask, and if all your analysis still can’t quite settle whether a specific deal is right for you, a credible network to reach out to is an invaluable vetting resource.